Financial Accounting for the Hospitality, Tourism and Retail Sectors Slide Handouts Chapter 9

Accounting for Fixed

Assets and Depreciation
Chapter 9

Luby & ODonoghue (2005)

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Capital & revenue

transactions
Capital expenditure is money spent to either:
Buy fixed asset, or
Add to the value of an existing fixed asset

Revenue expenditure is expenditure which does not

increase the value of fixed assets, but is for
running the business on a day-to-day basis.

Capital expenditure

1. Purchase cost of the fixed asset

2. Delivery cost
3. Installation costs
4. Inspection and testing before use
5. Legal costs in purchasing property and land
6. Architects fees for building plans and construction
supervision
7. Demolition costs

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Financial Accounting for the Hospitality, Tourism and Retail Sectors Slide Handouts Chapter 9

Transaction Classification
Purchase of computer system
Upgrading of computer system

Repairs to computer system

Extension to restaurant premises

Painting premises for first time

Repainting of premises
Purchase of machinery
Cost of transporting machinery

Light and heat bill

Building work to existing premises of which
one third involved repairs and two thirds
involved building an extension to the
property
Cost of rebuilding warehouse wall that had
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fallen down

Capital v revenue - vehicles

Transaction Classification

Purchase of van

Purchase of petrol for van

Initial tax and insurance on van

Tax and insurance on van there after

Spotlights

Company logo painted on van

Replacement engine

Incorrect treatment of capital

item
Should capital expenditure be incorrectly
treated as revenue expenditure the effects on
the final accounts are as follows
In the profit and loss account expenses will be
overstated and thus profit will be understated.
In the balance sheet fixed assets and total assets will
be understated as well as capital being understated.
(remember if profit falls then capital falls)

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Financial Accounting for the Hospitality, Tourism and Retail Sectors Slide Handouts Chapter 9

Incorrect treatment of revenue item

Should revenue expenditure be incorrectly

treated as capital expenditure then the effects
on the final accounts are as follows.
In the profit and loss account expenses are
understated and thus profit is overstated.
In the balance sheet fixed assets are greater and
capital is greater because profit has increased.

Subjectivity of classifications
Distinguishing between capital and revenue
expenditure can be a subjective process despite the
guidelines laid out by the accounting and taxation
bodies. Where this subjectivity exists there exists for
management and owners of businesses opportunities
to manipulate and create false and misleading
accounting statements

It is important to remember that a companys

eagerness to show strong profits (companies seeking
investors) can help even further to blur the distinction
between capital and revenue expenditure. The same
applies when a company prefers to show its more
impoverished side (submitting accounts for tax
purposes).
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Nature of fixed assets

Those assets of significant value which:
are of long life
are to be used in the business
are not bought with the intention of being re-sold

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Financial Accounting for the Hospitality, Tourism and Retail Sectors Slide Handouts Chapter 9

Depreciation
Fixed assets do not last forever

Depreciation is the difference between the cost of

buying and any proceeds on disposal
Cost of vehicle 80,000
Proceeds from sale 5,000
Depreciation is 75,000

Depreciation is the part of the cost of the fixed asset

consumed during its period of use.

Depreciation is an expense and is charged to the profit

and loss account

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Causes of depreciation
Physical deterioration
Economic factors
The time factor
Depletion

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Common methods of depreciation

Straight line depreciation

Reducing balance depreciation

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Financial Accounting for the Hospitality, Tourism and Retail Sectors Slide Handouts Chapter 9

Straight line method

Estimates are made for the number of years of use and
scrap or residual value

Cost - estimated scrap value

estimated number of years

Health and fitness equipment costing 90,000 with likely

residual value of 2,000 and usage of 8 years would be
depreciated by:

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Straight line depreciation

Ensures that deprecation is the same each year
Is popular due to its simplicity.
In some questions a specified percentage may be
applied.
If an asset is to be depreciated over four years, you
could be told to depreciate by 25 per cent per annum
straight line.
If an asset is to be depreciated over five years, you
could be told to depreciate by 20 per cent per annum
straight line.
The percentage approach will give you the same result
as the formula approach when there is no residual
value.

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Financial Accounting for the Hospitality, Tourism and Retail Sectors Slide Handouts Chapter 9

Reducing balance method of

calculating depreciation
Using this method the depreciation charge is a fixed
percentage on the cost in the first year and on the
reduced balance in later years.

A computer system costing 10,000 three years ago is to

be depreciated at a rate of 40 per cent reducing balance.

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Financial Accounting for the Hospitality, Tourism and Retail Sectors Slide Handouts Chapter 9

The key differences

Straight line
Calculated on original cost spent
Depreciation amount is the same amount each year

Reducing balance
Calculated on the net book value
Depreciation amount is different each year (reduces)

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Depreciation
The purpose of depreciation is to spread the
total cost of an asset over the periods in which
it is available to be used.

The method chosen should be that which

allocates the cost to each period in accordance
with the amount of benefit gained from the use
of the asset in that period.

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Accounting for depreciation

Double entry is
Account Amount

The annual
DEBIT Profit and Loss Account depreciation
charge
The annual
CREDIT The Provision for Depreciation Account depreciation
charge

Balance Sheet appears as

less equals
Historic Cost Accumulated Depreciation Net Book Value

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Financial Accounting for the Hospitality, Tourism and Retail Sectors Slide Handouts Chapter 9

Steps in accounting for

depreciation
1. Enter opening balances were necessary and update the
fixed asset account with any transactions that have
occurred during the period.
2. Balance the fixed asset account(s)
3. Calculate the annual depreciation and account for it by
Crediting the depreciation account
Debiting the profit & loss account
4. Balance the depreciation account(s)
5. If required show balance sheet extract by taking the
closing balances from the fixed asset and the
depreciation accounts.

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Accounting for depreciation

Returning to the health and fitness equipment
which was purchased for 90,000. It is
estimated that the residual value of the
equipment at the end of 8 years is a scrap value
of 2,000. The annual depreciation amounts to
11,000.

Show the accounting entries and the affect on

the final accounts for the first three years.

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Financial Accounting for the Hospitality, Tourism and Retail Sectors Slide Handouts Chapter 9

Depreciation policy
n To ignore dates during the year in which the assets were
bought or sold, merely calculating a full years
depreciation on the assets in use at the end of the year.
Assets bought get full years depreciation while assets sold
get no depreciation for that period
OR

o Provision for deprecation made on the basis of one

months ownership, one months provision for
depreciation.

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Tackling depreciation
questions
Find key information
Depreciation method
Straight line
Reducing balance

Depreciation policy
Value of assets at end of year
1 months ownership = 1 months depreciation

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Disposal of a fixed asset

If an asset is sold there may be a difference
between the net book value of the asset and
the proceeds of the sale.
Difference due to depreciation being an
estimate.
There will be a loss or profit if the amount
provided for as depreciation is different from
the actual deprecation that occurred.
A disposal account is opened to account for
the transactions.

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Financial Accounting for the Hospitality, Tourism and Retail Sectors Slide Handouts Chapter 9

Steps in accounting for a disposal

1. Transfer the original cost from the fixed asset account
to the disposal account
Credit the fixed asset account
Debit the disposal account
2. Transfer the amount depreciated on the asset sold
from the depreciation account to the disposal account
Debit the depreciation account
Credit the disposal account
3. Account for the proceeds of the sale
Credit the disposal account with the proceeds from the
sale
4. Find the difference in the disposal account and
transfer it to the profit & loss account

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Example
Alpha Hotels maintains its furniture assets at cost,
depreciating at a rate of 10% per annum using the straight
line method. The company has a policy of depreciating
assets in existence at the year-end. The following is
extracted from the balance sheet at 31 December 2003.

Accumulated
Cost depreciation Net book value
Furniture 200,000 122,000 78,000

During the year the business purchased new furniture for

30,000 on 5 May. Furniture, originally costing 18,000
when purchased in March 2000, was sold for 8,000 on 31
May.

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Financial Accounting for the Hospitality, Tourism and Retail Sectors Slide Handouts Chapter 9

Depreciation policy affects profit

The depreciation policy of a business directly affects the
level of net profit.

For example should a company decide to depreciate its

assets worth 2,500,000 over ten years on a straight line
basis then it would charge depreciation in the profit and
loss account of 250,000.

Should the company decide that the life of its assets is

closer to twenty years then the amount of depreciation
charged in the profit and loss account will amount to
125,000. Thus profit would be 125,000 greater due to
the change in estimate of the life of the asset.

Estimating the life of an asset can be a subjective

process.

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